10-Year Outlook: Why Central Banks May Concede Inflation Above Their Targets
Central banks likely will concede inflation rather than create undue economic harm
The diverging paths of economic growth and inflation has challenged monetary policymakers and investors. Aging populations, higher government debt, the green transition and regionalization are simultaneously holding back economic growth and supporting high inflation. We think central banks like the Federal Reserve and European Central Bank will concede inflation above their 2% inflation targets, which could impact the market outlook and portfolio construction for investors.
Diverging Inflation and Economic Trends
Over the next 10 years, we expect the developed-market annualized rate of inflation to come in at 2.4%. We forecast 2.6% for the U.S., with Europe lower at 2.2%. While a moderation from the elevated levels of recent years, this leaves inflation above the 2% level targeted by most central banks, including the European Central Bank, Bank of England and the Federal Reserve.
We expect changing global politics and deepening rivalries to contribute to structurally higher inflation. Pandemic-induced supply-chain struggles and China’s increasingly forceful posture have pushed the U.S. and Europe to prioritize building more reliable supply chains, especially with strategically critical technologies such as semiconductors.
As global trade wanes, the efficiencies globalization created over the past few decades likely will fade as well. We expect the new trend of regionalization to increase costs and sustain inflation. Similarly, the buildout of clean energy technology and manufacturing to support it likely will support regional energy stability and lower prices in the long-term. But in the meantime, we expect countries to rely on fossil fuels to support their economies, keeping commodity prices elevated.
While inflation has trended up, the global economy is trending down — and for similar reasons. Heavy investments to realign supply chains and counteract climate change will likely divert money from investments that would produce economic growth. Elevated interest rates will make high government debt levels more costly. Also, the economic drag of aging populations challenge most of the developed world and especially China. We forecast a 2.4% real annualized growth rate for the global economy over the next 10 years, an underwhelming expansion relative to the prior decade.
A Difficult Reality for Central Banks
Faced with the reality that these forces are beyond central bank control, we expect monetary policymakers to concede some ground and allow for modestly above-target inflation. Not doing so could be too costly in terms of lost economic growth and may open them up to political criticism regarding their somewhat arbitrary inflation targets. As central banks lay down their arms, we believe policy rates will start to decline in 2024. We forecast 10-year policy rates below today’s levels across most of the major central banks (Exhibit 1).
We expect that politicians, investors and consumers will likely need to adjust their behavior to this new era of higher rates, elevated inflation and less powerful central banks. Rising demands for public spending and aggressive investments to implement the green transition and regionalization will likely make the road bumpy.
The Impact on Investment Portfolios
For investors, Central Bank Concessions , one of our investment themes in our recently published 10-year outlook , may be important to consider when assessing the financial market outlook and building investment portfolios. At a minimum, it could result in modestly lower policy rates than the inflation regime would normally dictate. At a maximum, it removes central banks as the center of attention for financial markets.
Of course, that last part cuts both ways. Central banks may not hold the markets hostage with hawkish commentary and overly tight monetary policy, but nor would they provide the “central bank put” to markets when times get tough. We think the proverbial monetary flood is a thing of the past. From the perspective of the global economy and financial markets, conditions likely will continue to resemble something of a monetary drought.
To learn more about 10-year investment themes and return forecasts, visit our 10-year outlook website to download the full research paper.
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